Saturday, March 12, 2011

Michael Pettis on the Dollar, RMB, and Reserve Currencies

In yesterday's post, Currencies Stay Within Their Currency Zone, I made some remarks in the comments about reserve currencies and how different currencies are not in a position to replace the dollar anytime soon. Michael Pettis writes on this in detail with respect to Barry Eichengreen's saying that the dollars days as global reserve currency are numbered. I had been planning to comment on this in more detail than I did in the comments yesterday, but Pettis has saved me the trouble, especially regarding the RMB, which is supposedly a chief contender.

Pettis develops the issues to which I alluded in passing in. Basically, the RMB is not ready for prime time because China has pressing internal issues that prevent it from coming a key global player in the near future. He also notes that the euro is beset with problems, which he does not see clearing within five years.

Pettis concludes by showing how being the issuer of the global reserve currency is actually a cost to the US, and it would be better for US growth if a substitute where deployed. But he doesn't see that happening in the foreseeable future.

MMT Alert!

This is a straightforward post and easily understood until the end, where Pettis talks about US "borrowing." This jargon should be understood in MMT terms of Treasury securities issued in offset of budget deficits, which is imposed as a political decision rather than being an operational constraint inherent in the present monetary system. Budget deficits arise from demand leakage, one source of leakage being the current account deficit.

The capital account surplus is equivalent to the currency account deficit as an accounting identity. What this says essentially is that what a country spends (current account) externally it what is owes the rest of the world in terms of foreign ownership of domestic assets minus domestic ownership of foreign assets (capital account). The capital account includes foreign ownership of such domestic assets as foreign direct investment (FDI) in real assets, portfolio investment (stocks and bonds), reserves, and "other," such as bank accounts. US Treasury securities held by foreigners are part of the capital account.

If China wishes to export to the US, then it has to receive ownership of US assets, financial or real in return, unless goods are traded in equal exchange. The fact of there being a current account deficit makes China an owner of US assets that the US "owes" to China. Presently, China wants to save in liquid financial assets. It could hold reserves in its Fed account for this purpose, but Treasury securities pay interest, so that is the preferred choice.

Thus, it is somewhat confusing to say that the US is "borrowing" from China when China is actually "funding" purchase of its exports to the US through the capital account. At any rate, the end result is that US consumers and business get real resources from China, and China receives claims on US resources that it can exercise in the future, or sell to someone else through the foreign exchange market in return for another currency.

It is in this technical sense that foreign saving "funds" the current account deficit, often equated with the trade deficit, although the current account also includes net factor income (interest and dividends) and net transfer income (aid). It is this willingness to save in dollars that makes space for the US to increase its imports of real resources in excess of a direct exchange of goods.

It is a tautology that in a closed global economy not all countries can be net exporters or net importers at the same time. There has to be a balance between these, in which net exporters offset net importers, at least until Earth begins trade with other planets.

At present, only the US has the capacity to absorb the level of saving desired by net exporters, which is a fundamental reason for the persistence of the USD as the global reserve currency. The president's plan to export the US out of its problems by doubling its exports in five years looks unrealistic in today's world.

"It's the demand, stupid."

The US is the key source of demand in the world economy. Pettis observes how difficult it is going to be for China to increase consumer demand other than in small increments. This is true of most of the emerging world, because of institutional constraints. It is also true of the two most economically powerful countries beside the US, that is, Germany and Japan, because they are net exporters and bent on remaining so.

While Pettis does not draw this conclusion, the result is that only the US is capable of carrying global demand on its shoulders at this time. But since global capacity exceeds the demand that the US and rest of the world can absorb, the world is faced with a demand shortage, which manifests as massive unemployment and underemployment, as well as sub-optimal economic performance resulting in massive foregone opportunity. The present approach is not working and cracks are widening in the foundation. The fact that the dollar is a source of controversy shows this. On one hand, China wants to export to the US, and on the other, fears dollar depreciation that would affect its savings in dollars.

The challenge is to increase effective demand in order to grow the global economy. Ideally, this would evolve from a democratic new world order based on interdependence in a way that is sustainable financially, economically, politically, socially, environmentally, and ecologically. For this to happen, a fresh approach to globalization based on a new vision of possibilities and a grand strategy for achieving this vision are required. This is the discussion that we need to be having now. Neoliberal austerity is leading to economic underperformance and social unrest.


welfarewarfare state said...


Other countries do have the capacity to import those goods from other countries. The reason that the Americans have been able to fill this role is because the dollar has been artificially propped up by those willing to buy our debt. As other currencies rise relative to the dollar, we will lose the power to import at current levels while other countries make up the difference. If gold were the reserve currency, the trade imbalances of the U.S. would not have persisted for long.

I don't think the euro or the rmb will be the official reserve curreny anytime soon. I think that we'll see more bi-national agreements like the one between Russia and China from last year where they trade in their own currencies. It could be that paymetns could be settled in gold in the near future.

The dollar will problably not lose its reserve currency status anytime soon, but it will gradually be replaced by a combination of other currencies. In the end, I suspect that people will go back to settlement in gold.

America's status as reserve currency has allowed us to live beyond our means for decades so it has been a blessing and a curse. It gave us plenty of rope to tie our own noose.

Matt Franko said...


"the dollar has been artificially propped up by those willing to buy our debt."

Can you explain what you mean by "artificial" here? Is the "propping up" really not happening?

1. Man-made; of artifice.
"The flowers were artificial, and he thought them rather tacky."
2. False, misleading.
"Her manner was somewhat artificial."
3. Unnatural.

Which definition of "artificial" are you employing in your sentence? And can you explain the specific relevance for that definition in context?


Anonymous said...

When China sells to Germany, do they demand payment in US dollars?

mike norman said...


You said, "The president's plan to export the US out of its problems by doubling its exports in five years looks unrealistic in today's world."

It may be more realistic than you think. By supporting wage/demand destruction domestically, the U.S. may soon run a trade surplus. That would go far in "fixing" one of America's "problems," at least in the way that the president sees it.

Matt Franko said...

Non Sequitur, but if you dont mind 'sharing' :)

I believe you have a Doctoral Degree in Philosophy. But did you ever take calculus courses?

Reg.FD: I took very much calculus in College.

I came across this related to this kick I'm on wrt "Mathematical Maturity"

"Calculus is viewed as an excellent means by which to develop what is popularly termed ‘critical thinking’.

And also this research synopsis.

Excerpt: "Participation in a traditionally taught Calculus I
increases critical thinking ability..."

Is not 'critical thinking' a major area of study in Philosophy? Related to Socratic Method? The people in 'opposition' to MMT, if you will, seem to be extremely lacking when it comes to 'critical thinking' abilities, they are "locked in" some rules-based reality and cannot think their way out of it? Closed minded, etc...


Tom Hickey said...

Mike, when I said "unrealistic" I did not mean that the US cannot do this if it chooses. The president would not make the claim if he didn't think it possible. The US can usually get its way if it chooses to throw its weight around.

What is unrealistic is that this choice involves disadvantaging the US in real terms of trade while removing the primary source of demand from the global economy. It is based on a misunderstanding of monetary economics and global economics.

The MMT view is that imports are real benefits and exports are real costs, so the US is ill-advised to take the export route to resolving this issue, which is a pseudo-problem anyway. The persistent CAD need not be a problem if understood properly and approached realistically.

By attempting to export its way out of its perceived problems, the US is foregoing real benefits in real terms of trade. Other countries want to export their resources to the American market and are willing to save in dollars to do so. Saving is for future consumption or investment. Those saved dollars will eventually be spent or invested in the dollar zone.

The perceived problem for the US is demand leakage from the CAD that is reducing employment. There is the added influence of US foreign direct investment abroad that is exporting employment. Offshoring is, in effect, ersatz immigration. Both immigration and offshoring involve hiring foreign labor that is less costly than US workers. The US government cannot prevent this, because US business is behind it. But it is not necessary to prevent it either. Income at the bottom especially results in increased effective demand. The problem is dealing with people out of work, not trying to shut other people out.

While increasing exports would reduce the demand leakage from the CAD, it would not materially change outsourcing because US companies are selling so much outside of the US. GM is a major player in China and its foreign earnings exceed domestic. A lot of the "exports" would not result in US jobs, as falsely advertised.

The change in the global trade balance would affect emerging nations in a way that undercuts their growth, reducing incomes, hence demand there. This is a beggar-thy-neighbor policy that ill suits the global leader, especially when it is unnecessary. It makes Uncle Sam look more like Uncle Bully, and it is not a good strategy either politically or economically.

From the MMT vantage, the US should be using budget deficits to offset the demand leakage from increased domestic desire to save/deleverage and the persistent CAD, in order to close the output gap and achieve full employment ASAP. There is no good reason that there is a job shortage either in the US or world. The reason is ignorance.

MMT'ers would say that the US should institute an employment assurance program to achieve full employment (a standing job offer for everyone) along with price stability, the price anchor being the ELR wage/benefit package.

Warren is confident that if the US showed this example, the world would soon follow. This would mean that lagging world demand would reverse and the huge loss of foregone opportunity could begin to end.

Should the president be trying to create a more balanced world that fosters development, too, through something like the Seoul Development Consensus? Of course. But the US was the odd man out there at the G20 meeting. The US is still fixed on a unilateral approach.

This is what is unrealistic. Even if the US succeeds in doubling exports in five years, the problems will not only remain but also will have become magnified, because the wrong issues are being addressed. The president needs new advisors who understand the big picture in terms of monetary economics. "It's the demand, stupid."

Tom Hickey said...

Right, Matt, critical thinking is part of Phil 101. It is sometimes billed as Logic. I did take first year calculus as a college freshman, but that was over fifty years ago. :o

Both critical thinking and calculus involve nuance. Sophisticated thinkers are nuanced thinkers. Others are black and white.

Tom Hickey said...

Other countries do have the capacity to import those goods from other countries.

Really? Why don't they if they desire them and have the capacity? The fact is that everyone wants access to the US market, because the national pastime is shopping and there are a lot of us with credit cards itching to buy stuff. :)

The reason that the Americans have been able to fill this role is because the dollar has been artificially propped up by those willing to buy our debt.

You need to reread what I said where I explained this. If countries want to see us stuff, then they have to take ownership of our stuff or claims on our stuff, like tsys. This is the reciprocal relationship involved in trade. And any time China doesn't want dollars or our stuff any more, it can just stop selling us their stuff.

As other currencies rise relative to the dollar, we will lose the power to import at current levels while other countries make up the difference.

If the US dollar falls appreciably, imports might fall and exports rise, adjusting the CAD. But there is more to it than this, since countries intervene in the currency markets. Do you really think that other countries want US export prices to fall so that hungry US business can eat them alive?

If gold were the reserve currency, the trade imbalances of the U.S. would not have persisted for long.

Right, and world trade would be a lot smaller, and development would be retarded. A gold standard puts restrictions on growth. Read up on the history of mercantilism under metal. It becomes a gold rush that ends badly.

According to MMT, floating rates work fine to adjust trade balances if they are actually allowed to float.China is running a peg that undervalues its currency, for example.

The better answer is to let the system function based on its operational principles instead of either tweaking them or imposing an external standard.

Tom Hickey said...

When China sells to Germany, do they demand payment in US dollars?

When China sells into the Eurozone, they get either EZ stuff in return or accept financial claims, like bonds, denominated in euros. If they choose to save in euros, then they will eventually spend or invest the euros in the EZ, or else exchange them for another currency.

Matt Franko said...


A bit into the article Pettis states:

"remember that the current account surplus is equal to savings less investment"

Of course MMT states: (G – T) = (S – I) – (X – M)

ie: the Fiscal balance = (savings minus investment) minus (exports minus imports)

Which includes the fiscal balance in this equation.

I wonder if he is not aware of the fiscal implications on these mathematical identities; or perhaps he feels that in a Communist country, fiscal really "doesn't count" because 'everything is fiscal'; or maybe they dont pay taxes in China?

Tom Hickey said...

That struck me, too, Matt. I don't know the reason.

The basic equation is,

CA = (S - I) + (T - G)

It is worked out here:

Current Account Models and Saving-Investment Balance